Monday, October 12, 2009

A solid two years into the housing bust, the national foreclosure wave doesn't show the least signs of abating. Banks that had called a foreclosure moratorium are now back to the business of taking back properties, and the foreclosure numbers are again at record highs. As the foreclosures rise, so too does the criticism of “walkaways” who hand the keys to their drastically devalued houses back to the bank.

Last month a study from the credit reporting agency Experian and consulting outfit Oliver Wyman estimated that close to a fifth of troubled mortgages involved borrowers who were “strategically” defaulting—walking away from mortgages they could pay but decided not to because they owed more than their houses were worth. Self-assigned guardians of financial ethics see the willingness of borrowers to abandon their mortgage debts as a sign of the “erosion of social and moral standards.” The aim of these critics is to shame debtors into sticking with their mortgages. That's something debtors should take with a grain of salt. There are many good reasons to keep paying your mortgage and avoid the black mark of foreclosure, but the immorality of sticking the bank with a loss isn't one of them.

Some observers, like Zubin Jelveh of the New Republic, have taken issue with the Experian-Wyman study's methods, arguing that it was too broad in defining “strategic” default. But unlike some other reports that play up the number of deadbeat debtors, this study uses a fairly narrow and defensible definition to arrive at its conclusion that 18 percent of mortgage defaults are “strategic.” (Experian showed the report to The Big Money, but asked that it not be posted.) The study focuses on borrowers who, once they hit 60 days late, roll straight through to foreclosure without ever making another payment and manage to stay current on all their credit cards.

These are pretty good signs that someone could try harder to pay the mortgage—an idea supported by the fact that the borrowers who fit the model often had higher credit scores (and so probably more financial knowledge) and tend to live in states such as California, in which banks can't keep pursuing them for more money after taking their houses.

So let's say the Experian/Wyman study is right in its assessment that there are a fair number of strategic defaulters. Those who use this study and others like it to argue that the foreclosure problem is one of moral failure among borrowers are still wrong. Borrowers who walk away from mortgages calculating that they're better off taking the risk of not paying aren't abusing the system. They're using it the way it's designed to be used.

“Strategic default” is generally seen as an issue arising from laws in some states—including California, the reeling giant of the housing bust—that make traditional mortgages “nonrecourse," meaning they don't allow lenders to pursue any shortfall after foreclosing on a house. This is a bit of a simplification, as the actual rules are complicated, especially if multiple mortgages or refinancing is involved. In California, for instance, mortgages that have been refinanced are technically no longer “nonrecourse.” They remain subject, however, to the state's “one-action rule,” which forces banks to choose between a relatively quick nonjudicial foreclosure and a much longer and more involved process of suing for all the money they're due. As a practical matter, walking away from your mortgage is a more involved process than it might seem and not, as the critics sometimes imagine, simply a matter of living in a nonrecourse state.

Still, as the Experian/Wyman study convincingly shows, a meaningful number of debtors do calculate that they are better off walking away from a deep underwater house instead of exhausting their savings in the effort to “fulfill their obligations,” as the mortgage moralists like to put. Some of these, though not the majority, are investors who have mortgages on several properties. Others are ordinary folks, though often reasonably well-off (judging by the credit scores), who are financially savvy and want to protect their other assets.

The most vociferous critics of the walkaway phenomenon paint every debtor who abandons a mortgage before spending every possible dime to repay the bank as an abuser of the system. This is pure nonsense. Folks who lecture debtors pile on the ethical frosting with statements about how a mortgage involves a “promise” to repay and is so somehow inviolable. But one good way of judging whether a contract has the straightforward moral character of a “promise” is to check whether it is accompanied by many pages of fine print. Nonrecourse rules exist in the first place because some states saw more subtle gradations of what makes a promise—and decided that keeping people out of debt slavery was a higher public priority than assuring that banks get repaid.

But if those who are choosing between quitting their homes and flat-out penury are clearly not abusing the system, what of those who don't let it get to that point—the folks who calculate that having a foreclosure on their credit report is a better option than continuing to pay off their debts? In the telling of the moralists, letting these people walk away from mortgages creates a “moral hazard,” rewarding those who are willing to speculate with the bank's money. In real life, things are rarely this clear-cut—when it comes to the house they live in, few have so purely calculating a view. It is to some extent true that home buyers who can't be pursued for all their assets can make riskier choices. But that's not nearly the whole story.

The history of the recent mortgage boom is one of bankers racing to outdo one another in lending more money on the basis of ever-flimsier collateral. This is not a new phenomenon. It is a speculative mania, as has appeared in real estate time and again, and one reason for the restrictions on banks collecting the full face value of busted mortgages is to make it less common. These restrictions on banks are not some newfangled innovation. California's one-action rule, for instance, dates back to 1860, a period during which ranchers bid up the price of land, thanks to easy backing from lenders who encouraged speculation in the hope of quick returns. Even the term walkaway is by no means new—it appears in this nearly 50-year-old (and lecture-free) story from Time, which cautions bankers that if they keep making careless mortgages they'll have to deal with debtors who abandon them.

That old news story has things exactly right. It's banks, not home buyers, that are in the better position to judge the real estate market and how much their collateral is really worth. The bank approves the assessment and decides how much equity a home buyer will be required to put up. All the mechanics of mortgages are designed to let a lender avoid the situation in which it is owed more on a house than it is worth. The limits on banks' ability to collect on badly underwritten mortgages places the responsibility for judging the sanity of real estate loans in the hands of lenders.

Clearly in the last few years all these mechanisms failed utterly. They failed, not because of morally bankrupt borrowers who go back on their “promises,” but because bankers decided to count on a perpetually rising real estate market to absolve them of the necessity of responsible lending. Far from misusing the lending laws, borrowers who use the rights the law gives them to walk away from mortgages merely place the risks of insane lending where the law intends them to lie. What they do is not dishonest; on the contrary, a key reason we give borrowers the ability to do that is to keep bankers honest and responsible.

In periods of market insanity, this doesn't work. But don't blame the walkaways for exercising their rights. Blame the bankers who didn't worry about lending a whole lot more than they could get back in a foreclosure. The lesson of watching debtors walk away is a harsh one (not least for the taxpayers, who now effectively guarantee most mortgages), but the more bankers pay attention to it now, the better their chances of steering clear of the next bubble.